The current ratio as the name suggests has a look at a business's current assets versus the value of its current liabilities the reason why it's called a liquidity ratio is that this ratio is going to examine a business's ability to cover its short-term debts.
In this article, I'm going to show you how to calculate the current ratio, and then
I'm going to talk about ways that you can apply the current ratio to evaluate a firm's health. The current ratio is a measure of short-term liquidity. When we talk about short-term liquidity what we're basically trying to determine is whether a firm is in a position to pay its bills, its obligations that it's going to have in the coming year.
Let's just get to the nitty-gritty and look at the formula for computing the current ratio. In the numerator, we have current assets and in the denominator, we have current liabilities. When we think about the things that are included in current assets and current liabilities
we're going to have things like accounts receivable, cash, inventory maybe the firm has some kind
of short-term marketable securities. These are the common things that we would find in
current assets and then in current liabilities, the main thing that's going to stand out is going to
be accounts payable, and then also you'd have as the current portion of long-term
debt.
Free Current Ratio Calculation Excel Template
So we've got our obligations that are in becoming due in the next year and then we've got the most liquid of our assets. Our cash obviously is cash so we don't have to worry about liquidity there,
accounts receivable can easily be factored and turned into cash, securities can be easily turned into cash and we'd
like to hope that our inventory can be turned into cash.
When we think about these things what we're really trying to find out here with this the current ratio is do we have enough assets that are liquid that could cover those obligations?
Let's use an example here, we're going to look at a couple firms and bear in mind that a higher current ratio is going to imply higher liquidity. So let's put some numbers to this,
let's say that in terms of current assets firm one has 270 dollars and
then firm 2 has 320 dollars, and then in terms of current liabilities firm
one has 225 dollars in current liabilities and firm 2 has 400. Now we just want to
calculate the current ratio.
Let's go back and let's look at this simple formula, we just take the current
assets and divide them by current liabilities. We just take the current assets divided by
the current liabilities and so for firm one I've already done the calculation and it's going to
be 1.2 is the current ratio and then for firm two it's going to be 0.8, we just take
this 320 and divide it by the 400 and that gives us 0.8.
So let's think for a moment and say is this intuitive what we did, because we've got
a higher current ratio for firm 1 so that's implying the firm one has higher liquidity. Let's think
about is intuitive so firm 1 actually has more current assets than current liabilities so if we were to subtract, if
we just forgot about computing this ratio for a moment and just set that aside and we subtract the liabilities from
the assets for Firm 1 we would have a positive number, in other words, there are more current
assets than there are current liabilities and that implies that the firm is liquid.
Relative to firm 2 we have a situation where actually current
liabilities are more than the current assets so just assuming right now that the firm had to take whatever current
assets it had and try and pay off its current liabilities, firm 2 would be more of a buying potentially than firm
one.
Now one caveat to that this current asset figure is including inventory. So if the firm is having some kind of financial problems or if there's a downturn in the economy there's some kind of problems
then inventory could be a big question mark. Let's say there's a depression or a recession the firm might have
trouble moving some of its inventory and so the inventory might not be that liquid, it might be something we maybe
don't want to include that in current assets we know that receivables and cash and marketable securities are
liquid but inventory and certain times might not be that liquid in such cases the current ratio might not be the
thing that we want to be looking at would actually look at something called the quick ratio which is what we're
going to talk about in the next article and it's something that's basically the same thing as the current ratio
except it excludes inventory.
